Comment by phil

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phil
February 10th, 2016 at 12:10 pm

Here's my notes for Money Talk later:

Show notes: 

Segment one, economic overview. 

This is our Big Chart, where we use our 5% Rule to determine the likely trading range for our indexes. 



We set our Must Hold lines based on what we consider the fair value for our indexes for the year with a 10% up and down range we expect. 

On August 13th, we wrote an analysis of the S&P 500 and, at the time (with S&P at 2,095) we decided to short back to our levels saying:

 

So, upon further examination, there is no change to our stance of being short the markets at these levels which, on the Futures this morning, are 17,400 on the Dow (/YM), 2,095 on the S&P (/ES), 4,550 on the Nasdaq (/NQ) and 1,212.50 on the Russell (/TF) and, as usual, we look to short the laggard of the set with tight stops above.  We also took on a more aggressive SDS (ultra-short S&P) position yesterday afternoon – as we felt the run-up was nonsense anyway – this post just confirms our gut reaction.

http://www.philstockworld.com/2015/08/13/thoughtful-thursday-contemplating-the-sp-500/

That was, of course, followed by the August flash crash – right back to our lines, where we played long back to the top.

On Jan 14th of this year, we wrote an analysis of the Dow, where we called a valuation bottom at 16,000 (where we are again today), saying:
 

So, overall, our 30 Dow components look like they are only good for about 700 Dow points, which is only twice as much as they lost yesterday.  The good news is we can call a bottom here (16,000) but the bad news is we're not likely to go anywhere from here and what goes for the Dow likely goes for the other indexes as well. 

Fearful Thursday – Are the Markets DOOMED? Breaking Down the Dow

Currently the macro environment is choppy but mostly it's a huge rotation out of energy and materials (sorry Canada) and into consumer staples and blue chips, which is fairly normal.  Oil exporters, like Canada, are being stung by the shifting dynamics but the good news is jobs are coming back and wages are rising in other sectors:





Segment 2:  Why oil is not coming back.  Currently, according to the IEA, there is currently 1.75mb/d more oil being produced than is being demanded and OPEC supplies 1/3 of the World's oil so, if they have to cut by themselves, they would have to cut over 5% of their production to balance supply with demand.  Even if their members agreed, they would then have to not cheat for many months before it had a real effect on the markets and they'd also have to hope that the other 2/3 producers didn't begin pumping more oil to fill the gap and steal their market share. 

The real problem for oil producers is on the demand side but demand is not very price-elastic, so low prices aren't increasing demand. 

We have to think about the rigid and limited mind-set of the average analyst, who think that low oil prices mean a bad economy because, clearly, demand must be off.  That was a very solid assumption since the birth of the internal combustion engine but now that we have electric cars and solar and wind power – it's no longer such a direct correlation.  While we do have an oversupply of oil, to be sure – it's wrong to blame it on a slow economy.  

One solid example of this is auto demand.  You are probably aware of the fact that auto sales hit records in 2015, with 50M cares delivered globally.  While this is somewhat a bump in demand, it's mainly about replacement cars and what kind of cars are we replacing?  The average age of the US fleet is 11.5 years and we can safely assume that most cars being replaced fall on the longer end of the scale.  Well, the average car in 2005 got just 22 miles per gallon and we're replacing them with cars that get 35 miles per gallon (new car fleet average) thanks to Obama's CAFE standard rules.  And it's not just the US – the whole World is getting more efficient:



A car being driven 15,000 miles a year (average) that used to use 750 gallons at 20 miles per gallon is replaced by a car driven the same 15,000 miles a year that now gets 35 miles per gallon and used 428 gallons.  That's 42% LESS fuel than the previous car!  An oil barrel is 42 gallons and it's not all refined to gasoline but let's just say that each new car sold requires 10 less barrels per year than it's predecessor.  At 50M cars a year that's 500M less barrels per year required for our auto fleet – a 1.5Mb/day demand cut that becomes 3Mb/day in year 2 and 4.5Mb/day in year 3 and THAT is where our demand is going and it's NOT coming back!  

In fact, we also are getting more efficient trucks and more efficient planes and more efficient machines in our factories and a lot of equipment is using wave, wind and solar energy for power and not using any oil at all to run.  So our economy could be off to the races and oil consumption would still be going downhill and, ironically, the better our economy does the faster the old gas-guzzling machines get replaced and the faster the demand for oil declines but that's a GOOD THING, not a reason to panic.

Yes, there will be disruptions as we move into a post-oil economy – especially for economies that depend on oil.  Saudi Arabia alone has enough oil in the ground to supply the World for 40 years and, sadly, it's not likely they'll even use half of it before oil is a fuel of the past and THAT is why no one wants to cut production – despite this persistent glut that is without end – because they know they are playing a game of musical chairs with oil barrels and they are all going to be stuck with a worthless fuel of the past with a rapidly declining inventory value. 

This is also bad news for companies like Exxon (XOM), Chevron (CVX) which are, unfortunately, Dow Components.  It's bad news for the energy sector and the banks that lent them money so there WILL be disruption – but it's the good and healthy kind as our society moves on from using oil and it's NOT a sign of a slowing global economy – that's why we flipped long this morning! 

Segment 3:  Trade Ideas

While there is likely to be more pain in the energy sector, we do like natural gas, which can be played with the UNG ETF, now at $7.42 with natural gas at $2.02.  Beginning next quarter, the US will begin exporting natural gas to other countries.  While Canada mainly will be exporting their natural gas to Asia, the US will mostly be exporting to Europe. 


Natural gas is $5 in Europe and $8 in Asia.  Adding the North American surplus supply to the mix will lower prices globally but will raise prices at home in the US and Canada.  While the numbers may look small, these first 9 terminals add up to almost 1/3 of the current US natural gas output scheduled for export.  The assumption is that, over the next two year, more supply will come on-line to balance it out but, until then, expect some pretty big price swings. 


That makes the natural gas ETF, UNG, our Trade of the Year and the way we are playing it is:
 

• Buy 100 UNG Jan $5 calls for $2.65 ($26,500)
• Sell 100 UNG Jan $10 calls for 0.65 ($6,500) 
• Sell 50 UNG 2018 $8 puts for $2.10 ($10,500)

That works out to a net cost of $9,500 and pays $50,000 if UNG is above $10 in January and stays above $8 into Jan 2018.  Worst case is you end up owning 5,000 shares of UNG at net $8.95 ($44,750), which is about $2.40 on /NG contracts.  Best case is you make a $40,500 profit on a $9,500 cash bet, which is 426% back on your cash!

Another trade we really like down here is Ford (F), who have fallen back to $11.40, well below our $15 target.  The US fleet has an average age of over 11 years so we're only mid-way through the replacement cycle and our play on F would be:
 

• Buy 100 F 2018 $9.75 calls for $2.45 ($24,500)
• Sell 100 F 2018 $12 calls for $1.35 ($13,500)
• Sell 50 F 2018 $9.75 puts for $1.50 ($7,500)

The net cash outlay is $3,500 and there is an obligation to buy 5,000 shares of F at net $10.10 ($50,500) if it slips below $9.75, which is down 14% from where we are now.  If all goes well and F gets back over $12 then the short puts expire worthless and the trade returns $22,500 for a $19,000 profit, which is 542% on cash in less than 2 years. 

For people who like to own stock, it's also possible to play F the following way:
 

• Buy 5,000 F shares at $11.40 ($57,000)
• Sell 50 2018 $9.75 calls for $2.50 ($12,500)
• Sell 50 2018 $9.75 puts for $1.50 ($7,500)

Here we're laying out $37,000 but the advantage is that we will collect a 0.60 dividend ($3,000) in each of the two years of this trade for a bonus $6,000.  Our net entry is just $7.40 per share and, if we are called away at $9.75, we profit another $2.35/share ($11,750) for a total profit of $17,750 over the trade (48%) which is very nice for people who prefer to own stocks and not gamble on options.  The nice thing about this trade, of course, is F can drop 14% and you still make your full 48% as it's a very conservative target. 

It's also worth noting that in both of these cases, simply making a short put sale puts money in your pocket and gives you a tremendous discounted entry on the stock (or you keep the cash) – that's worth discussing as part of our "Be the House – NOT the Gambler" strategy. 

Thanks,

– Phil